Brookings-Wharton Papers on Financial Services 2001 (2001) 281-329
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Infrastructure Requirements in the Area of Bankruptcy Law
Clas Wihlborg and Shubhashis Gangopadhyay
with contributions by Qaizar Hussain
[Comment and Discussion]
INFRASTRUCTURE REQUIREMENTS HAVE long played an important role in the development debate. Until recently, these requirements referred to the need for improvements in roads, railways, electricity supply, telecommunications, and the like. Lack of such infrastructure was seen as an important cause of a country's relative poverty. Yet investments in physical infrastructure have not spurred growth in developing countries.
The search for the root cause of economic development has led the mainstream of economists to examine the system of rules for economic activity. The attention to rules and institutions became widespread only after the fall of communism, although Nobel Prizes were awarded to Friedrich Hayek and Gunnar Myrdahl in 1974 and to Ronald Coase in 1983 for their contributions to institutional and political economics. These prizes represented a recognition that institutional and political economics help to explain important aspects of the organization of economic activity, but few economists took the additional step of analyzing institutional factors as root causes of development and growth. An exception was Douglass North, who received a Nobel Prize in 1993 after the fall of [End Page 281] communism and renewed interest in institutional economics. This interest was sparked, to a large extent, by the failure of the formerly centrally planned economies to start growing. Economic research began to focus on social institutions in general, and the legal system in particular, on defining and securing property rights, on enabling trade, and on providing incentives for economic activity.
Among social institutions, the legal system is most directly subject to change, at least with respect to the letter of the law. Thus it is natural that policy-oriented economists would emphasize legal reform to enhance the incentives leading to economic growth.
Economic growth requires that old activities be phased out to make room for new ones and that economic resources be reallocated from activities that no longer are profitable. This reallocation can occur within a variety of organizational structures, but the failure of projects and firms must be seen as an inherent aspect of the growth process.
The Asian crisis and a large number of more or less severe banking crises in a variety of countries during recent decades have raised questions about the ability of economic systems to deal with widespread failure of firms. Caprio and Klingebiel refer to the lack of procedures for banks to settle and recover claims on distressed firms as a cause of lingering and recurring banking crises in many countries. 1 Krugman notes that, before the crisis, investments kept flowing to projects of questionable value in many Asian countries. 2 A mechanism for abandoning unprofitable projects seemed to be missing. In the Eastern European transition economies, state-owned enterprises or formerly state-owned large enterprises producing negative value could not be closed down in an orderly fashion. Laws, procedures, and court capacity were missing. Bankruptcy law was implemented in several countries with mixed results, as is discussed in this paper.
Although there may have been too few bankruptcies in Asia and Eastern Europe, the argument in the Swedish policy debate after the banking crisis of the early 1990s was that there were too many bankruptcies of viable firms and that the recession therefore became unnecessarily deep.
These experiences indicate that the procedures for dealing with insolvent firms may affect economic growth as well as the depth and duration [End Page 282] of crises. In this paper, these procedures, and the institutions and organizations involved, are viewed as the infrastructure for bankruptcy. At the center of the discussion stands insolvency law for firms and the court systems supporting the law, but the bankruptcy infrastructure could be considered much broader, including or relating to a wide array of formal law and informal procedures. Informal procedures for insolvency are as important as the law, and they necessarily involve banks as the major creditors. Therefore, laws and regulations for financial...